Interpretation of the DRC results

a_ij , k+1 to n - technical coefficients for domestic resources, V_j^p - private price for domestic factor j,

P_i^p - private price of traded output i, P_j^p - private price of traded input j,

The PCR <1 whenever an activity generates positive private profits.

3.1.3 Interpretation of the DRC results

Favourable DRC means that at the current input productivity (technology and efficiency) represented by the technical coefficients used in estimation, an activity offers an efficient employment of scarce domestic resources. The exogenous (to the activity) determinants²³ of this efficiency include: (i) the

22 Consider the following series of three activities only differing in terms of the proportions of domestic resources in total costs:

Social costs Social revenues

Domestic resource Tradable inputs NEB SCB DRC

10.0 3.0 6.0 1.0 0.90 0.75 10.0 4.5 4.5 1.0 0.90 0.82 10.0 6.0 3.0 1.0 0.90 0.86

23 This is true under the ‘small country‘ assumption (i.e. changes in the county’s export or import volumes have

3 Recent Comparative Advantages 42 shadow prices and exchange rate reflecting the structure of economy and (ii) world prices of tradables reflecting the world market supply-demand conditions. Since the return to domestic resources exceeds the marginal return economy-wide an expansion of the activity up to the level where the DRC would breakeven (DRC=1) would bring a gain in GDP (interpretable as an improvement in the economy’s allocative efficiency).

Average versus marginal DRCs

This general conclusion is, however, complicated by the average character of the coefficients usually used, which is also the case in this study. Since the industry (or any sample of enterprises) consists of production units differing in terms of technology and efficiency, the desirability of expansion only and always concerns the units for which individual DRC are favourable (DRC<=1), i.e. even in industries with unfavourable average efficiency some firms may have favourable DRCs and in industries with the favourable average values some firms may be inefficient. At the same time, the difficulty in identifying the extent of the desired expansion stems from the simultaneous changes in at least some of the social prices (e.g. for industry-specific non-tradable inputs like farm milk in the milk processing industry). This requires an analysis of DRC at the margin of the industry to spot the breakeven industry size.

Some of these shortcomings can be partly offset by complementing the analysis with descriptive statistics on structural characteristics and on discrepancies among enterprises in terms of economic performance like the data presented in the previous chapter of this study. This provides information about the existing deviation from the considered average and the extent and the nature of the inefficiencies for marginal enterprises. Further discussion, then, will be subject to all the qualification associated with the ‘average’ character of the technical coefficients used.

Constant technology assumption

In estimating social costs by accounting only for divergences in prices one makes the assumption that industry would operate at the same technology if the social prices prevailed. In other words, input productivity and input mix are assumed not to be affected by the divergences in prices. Since the information required to account for technology adjustments is virtually not available (technology and efficiency responsiveness, and the substitution elasticities among inputs) in practice the effects are usually ignored²⁴ (Valdes and Schaeffer, 1995). Nevertheless, it is possible in certain cases to determine a priori the directions of the underlying biases (Tsakok, 1990).

no influence on the world prices of tradables it faces) and ‘small industry‘ assumption (i.e. changes in the industry’s employment of domestic factors have no influence on the factor prices it faces).

24 A recent study of comparative advantages in Poland and Hungary based on combined general equilibrium and partial equilibrium of food market by Banse et al. (1998) have accounted for substitution effects between capital and labour taking an assumption on elasticity of substitution based on literature review.

3 Recent Comparative Advantages 43 For example, enhanced private profits (PCR<DRC) means that operating under the social prices the entrepreneurs would face higher pressure to improve productivity of inputs. Such adjustment would bring an improvement in the estimates of DRC compared to the values based on the ‘observed’

coefficients, i.e. in such a case estimates of social profitability tend to understate true social profitability. In analogy, the opposite bias is expected for cases where profits are depressed (PCR>DRC) – social profitability tends to be overestimated. Second, the substitution among inputs is assumed to a have a cost minimising effect at any level of output. For this reason, whenever the coefficients reflect input-mix observed at private prices, neglecting substitution means underestimating the social profitability.

Link between social profitability (DRC) and private profitability (PCR)

Unfavourable DRC raises the question of what makes the observed activity viable. The first and general answer is suggested by the private profitability demonstrated by the PCR – despite being socially unprofitable the activity may enjoy profitability at financial prices. Private profitability can be seen as a net outcome of the ‘level’ of comparative (dis-) advantage and the effects of the existing divergences in markets. Hence measures of such divergences must provide for a link between the measures of private and social profitability.

Two indices of distortions in the markets are useful here. First is the nominal protection coefficient (NPC), the ratio of private and social prices measuring a divergence in a single market: for an output or input (it is market specific). Second is the effective protection coefficient (EPC) which measures combined effect of distortions in output and tradable input markets on a given activity (it is activity specific). The effective protection measures the change in the return to the ‘value added product’, of the domestic resources, resulting from the distortive policies in both product and tradable input markets (Corden, 1971). The NPC and EPC can be presented using the notation from equations (3.1) and (3.4):

From equations (3.1), (3.4) and (3.7) the following relationship between the PCR and DRC can be derived:

3 Recent Comparative Advantages 44

where the last term of the right-hand side of the relation measures the average distortion in the markets for domestic resources (here capital and labour). It can be referred to as a coefficient of distortion in domestic factor costs (DDFC). Like the EPC the DDFC is activity-specific, as it is the function of the price divergence in each factor market and the activity-specific intensities in factor.

Hence:

Since private profitability (PCR<=1) is the necessary condition for an activity to stay viable it follows that:

This means that to stay profitable an activity lacking comparative advantage (DRC>1) requires transfers either through tradable output and input markets (EPC>1) or/and in a form of policy distortions or market failures cheapening (relative to ‘shadow’ prices) the costs of domestic factors (DDFC<1). At the same time, in a case of undistorted domestic factor costs²⁵ (DDFC=1) an activity to stay privately profitable must receive effective protection at least equal to the value of the domestic resource cost (EPC >= DRC).

It seems obvious that unfavourable DRCs suggest two alternative reactions targeted at sustaining economic viability (private profitability). First, an efficient one consists of improving factor productivity (decreasing DRC), by eliminating inefficiencies or adopting new technologies. Second, an inefficient one, is to try to influence the price-determination in output and input markets by political lobbying or imperfect competition practices (increasing EPC or decreasing DDFC).

Equation (3.9) presents the effects of divergences using EPC and DDFC, which aggregate effects in various markets faced by producers. These effects can, however, be presented in a desegregated form using the policy analysis matrix (see section 3.1.5). In this study four groups of inputs are separated in the PAMs: tradables, capital, labour and farm milk. Moreover, in output markets, total

25 Or distortions that balance out.

3 Recent Comparative Advantages 45 divergence is disentangled into direct policy effect (trade policy) and the remaining, unexplained effects (structural and market failure).

A comment on the tradition of DRC analysis

Traditionally the DRC has been used as an ex-ante measure of project evaluation under conditions of distorted exchange rate and distorted prices (Bruno, 1972), and in an ex-post context as a measure of the costs of maintaining unprofitable activities through trade protection (Krueger, 1972). In some studies it has been used to simulate dynamic comparative advantage during periods of policy liberalisation and regional integration (Pearson et al., 1987 for Portugal, Münch et al., 1997 for Poland). In most uses the DRC serves to rank activities in terms of the comparative advantage for policy-making purposes (Monke and Pearson, 1989).